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Medicare Part D Proposed Restructuring Would Be Impactful To Pharmaceutical Companies

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Includes: ABBV, AMGN, AXGT, BCEL, BMY, DRRX, LOGC, MRK, NTLA, NVS, PFE, REGN, RHHBY
by: Leonard Yaffe
Summary

The proposed Medicare Part D drug payment reforms could result in considerable savings for the government.

Medicare Part D represents about 30% of total US pharmaceutical spend.  If the government's share of catastrophic coverage is reduced from 80% to 20%, the plan sponsors will demand greater discounts.

I am reminded of the phase in of DRGs over 35 years ago and the negative effect it had on hospital chains and commodity medical suppliers.

Until the dust settles, I believe investors should avoid stocks that have significant exposure to the Medicare Part D, and Medicare Part B, proposed reforms.

Unlike many prior proposals that would have minimal impact in controlling the cost of pharmaceuticals, two recently proposed legislative actions could meaningfully reduce Medicare drug spending. One is aimed at Medicare Part D, which represented $100 billion of the $130 billion spent by Medicare on pharmaceuticals in 2016, and the other, at Medicare Part B. Regarding the Part D spend, by shifting more of the responsibility for payments to the plan sponsor from the government, greater pressure will be placed on the drug companies for more favorable pricing. The Trump administration proposal for Medicare Part B drugs that would shift reimbursement to an international pricing index (IPI) could lower prices by 30%.

In Medicare Part D, the proposed change in catastrophic coverage would increase the plan sponsors’ responsibility above the catastrophic coverage threshold to 80% from 15%, and reduce the government's obligation from 80% to 20% over four years. This focuses on a portion of the Part D benefit that is out of control, and reflects the growing contribution of specialty pharmaceuticals. Federal payments for catastrophic coverage rose from $10.8 billion in 2010 to $33.2 billion in 2015, and accounted for 42% of Federal payments for Part D.

Importantly, drug spending for high-priced drugs (price greater than $1000 per month) in catastrophic coverage rose almost seven-fold in this five-year span, and represented about 65% of the total pharmaceutical spend in this area. Furthermore, 10 drugs accounted for 30% of the total, and the disease states were Hepatitis C, oncology, inflammation, multiple sclerosis and chronic kidney disease. Nine of the 10 are considered “specialty pharmaceuticals".

The proposed change in reimbursement methodology should result in lower prices demanded by plan sponsors for expensive biologicals. These drugs account for 1% of total US prescription volume, but represent 44% of total costs. Furthermore, they account for 60% of the annual increase in drug spending. Key drugs include Revlimid, Eliquis, Januvia, Lantus, Advair, Ibrance and Imbruvica. Furthermore, price increases for several of these drugs have been impressive.

Regarding Medicare Part B, proposed changes by the Trump administration would shift to an international pricing index (IPI) model. This is intended to lower reimbursements by an average of 30%. However, as noted above, the total spend on this program is small, and relevant only to a few companies. Top spending drugs include Eylea, Rituxan, Opdivo, Neulasta, Remicade and Opdivo.

The net effect of these two proposals, if enacted, would be to cause a downward revision in earnings estimates for several drug companies, which in turn would likely attempt to shift some of the lost revenues to the private sector and also introduce new drugs at a higher price. It would accelerate the consolidation of the industry, increasing the attractiveness of companies with less exposure to Medicare and placing a premium on promising drugs in late stage development.

It took about a decade for hospital chains and manufacturers of commodity medical products to recover from the implementation of DRGs in the early 1980s. The DRG reimbursement methodology was phased in over a four-year period. It changed hospital payments for an admission to an assigned rate, excluding outliers, instead of the hospital being reimbursed for its charges. Medicare hospital payments had risen from $3 billion in 1967 to $37 billion in 1983.

DRG-based payments served to encourage cost efficiency, and prices of commodity medical products rapidly declined, even though the program was gradually phased in. It also took hospital companies several years to achieve appropriate staffing levels and to standardize buying patterns. I expect the growth rate readjustment for pharmaceutical companies, if these proposals are enacted, to be at least three years. Until the dust settles, I would recommend avoiding stocks such as Regeneron (REGN), AbbVie (ABBV), Merck (MRK), Pfizer (PFE), Roche (OTCQX:RHHBY), Bristol-Myers (BMY), Novartis (NVS) and Amgen (AMGN).

I would instead focus on smaller companies, including Axovant Gene Therapy (AXGT), Atreca (BCEL), LogicBio Therapeutics (LOGC), Intellia (NTLA) and DURECT Corporation (DRRX), as well as the medical supply and diagnostics companies. I have observed the underappreciated negative effect of government reform on stocks for the past 35 years, including DRGs, IOLs, home healthcare and skilled nursing facilities. The common denominator has been analysts being late to realize the impact.

Disclosure: I am/we are long BCEL, DRRX, AXGT, NTLA, LOGC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short PPH. I am long LABD.